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The London forex market is the reason for the country’s crucial place in the global financial services industry. The UK has a strategically important geographical location. Banks in London are well placed to deal with North America, the Far East, the Middle East and the rest of Europe, throughout the span of a working day. This factor, combined with the fact that the Pound Sterling was once the dominant international currency, and that London is a prominent destination for foreign investment, makes the London FX market the largest in the world.
In July 2019, the Bank of England released its semi-annual survey, conducted on 28 financial institutions, which revealed that daily average FX turnover in the country had grown 12% between October 2018 and April 2019, reaching a figure of $2.86 trillion. The biggest contributors to this record increase were foreign exchange swaps and currency forwards.
This surge is surprising, considering that Britain is facing extreme uncertainties due to Brexit. So, why are investors trading more FX than ever before?
In December 2018, the US Federal Reserve indicated a rise in interest rates, for the fourth time in the year, while also suggesting that it would continue to do so in the future. In response to this announcement, there was a massive sell-off in global equities, by investors who were expecting a much more soothing tone from the Chairman of the Fed.
The S&P 500 dropped 2.3%, and the yield on the 30-year US Treasury fell 8.7 basis points. Even the Asian and European markets were affected, leading to declines in China’s CSI Index, Japan’s Topix Index and also the Euro Stoxx 50 Index.
As a result, the world’s major central banks, led by the US Fed, decided to change their stance on monetary policies. It was during this time that FX trading rose in volume. Although the Fed cut interest rates in July 2019, for the first time in a decade, the rates remain the highest in the world.
The jump in FX turnover has been led by US investors in the UK and UK investors in the United States, who have resorted to hedging activities, capitalising on the high interest rate differentials between the currencies of the two nations. The survey has clearly stated a rise in trading volumes for both the EUR/USD and GBP/USD, which rose by 18% and 16%, respectively.
This also indicates that Brexit uncertainties are high on the investor’s mind.
Forex volatility has been on a record low in 2019, thanks to the increasingly dovish stance of the central banks, globally. While extreme volatility is not favoured by traders, moderate levels are needed for trading opportunities.
However, low volatility is good for carry trades. In carry trade strategies, investors borrow in currencies with lower interest rates and then invest it in currencies that have high yield, for instance, the emerging market currencies. The gain comes from the difference in interest rates, also known as “carry.”
Certain conditions need to be in place for such trades to work, such as global liquidity, benign global economic backdrop and low volatility, all of which are present in the current markets.
As the US has lowered its interest rates, conditions are ripe for money flowing into the emerging markets. Carry trading is on the rise again. According to HSBC’s Global FX Carry Index, in 2019, FX carry trades have increased 5.5%. Experts say that this trend is likely to continue while rates remain low and economic growth is moderate. On the other hand, if the US records strong economic growth, the Fed could re-evaluate its stance.
For now, the favourite currencies for carry traders seem to be the Swiss Franc, Euro and Japanese Yen, all of which are good funding currencies, due to their low yield. The Swiss short-term rate is already at negative levels, and it seems that the government might further decrease it.
But such trades are highly risky in nature. Much will depend on the resolution of the US-China trade conflict. If the US economy deteriorates and the on-going trade war escalates, there will be significant volatility in the market, which will make currencies like the Euro and Swiss Franc costlier. This will result in money flowing out of the emerging markets.
Central Bank policies in Europe and Japan over the last few years have made it clear that there is no downward limit when it comes to interest rates. Debt levels in the US and other parts of the world are surging, and money is being injected into the economy at a steady rate. All this and more has led to a systemic depreciation of all currencies. If the US further reduces its interest rates, the rate differentials between the US Dollar and other currencies will continue to widen.
A significant portion of the surge in turnover has been attributed to a rise in USD/CNY trading. The turnover has increased to $73 billion per day, surpassing the EUR/GBP as the seventh most traded currency pair globally.
Over the years, London has become a prominent hub for trading the Chinese Yuan, which has translated into these figures. China, one of the world’s largest trading nations, continues to spread its efforts for internationalising the Chinese Yuan or Renminbi (RMB), by facilitating economic reforms and global trade. Its bid to intensify the use of the Chinese Yuan in global transactions is clearly a threat for the US Dollar, as well as one of the reasons for the ongoing trade war.
Moreover, China has pursued payments for oil imports in its currency. Countries like Russia, Angola and Saudi Arabia, the top oil exporters to China, have agreed to these conditions.
Overall, volatility has been down in the forex market, owing to more or less similar policies adopted by the Central Banks worldwide, in holding down interest rates. But FX traders seem to have found ample opportunities even in the dovish climate, such as through options based on exchange rates, lying between specified ranges. Forex derivatives like CFDs and options have also been popular in tackling periods of uncertainties. Also important is the use of robust risk-management strategies.
